The S&P 500 Could Gain Another 10% Next Year, Experts Say
This year brought heartache to Main Street but joy to Wall Street. Next year, if vaccines vanquish the coronavirus, as expected, and the economy rebounds, it could be a time of celebration for both.
Even though U.S. stocks are at all-time highs today, market strategists see the S&P 500 index rising further in 2021, propelled by a stronger economy, robust profit growth, and still-massive stimulus from governments and central banks, which paved the way for this year’s advance by keeping interest rates near zero. Even better, the market’s leadership could broaden well beyond big tech stocks to encompass financials, industrials, and other economically sensitive shares left behind by 2020’s rally.
As the year unfolds, however, expect more talk on Wall Street about the potential consequences of the government’s largess, namely resurgent inflation and an eventual rise in rates, which could put a lid on the market’s ebullience in 2022. But that’s getting ahead of the story, just when the plot is about to improve.
Barron’s recently surveyed 10 market strategists and chief investment officers at large banks and money-management firms on the outlook for 2021. Averaging their year-end S&P 500 forecasts, which range from 3800 to 4400, the group expects the index to rise some 9% next year, to about 4040. Add a dividend yield of around 2%, and U.S. stocks could return a total of 10% to 11%—no mean feat after this year’s 17% return, which lifted the S&P 500 to 3700 through Friday.
Our panel sees the U.S. economy growing by 5% in 2021, its fastest rate since 1984. That’s after a year in which gross domestic product plummeted by 31.4% in the second quarter, as the pandemic gripped the country, and soared by 33.1% in the third, as the Federal Reserve and the government rode to the rescue with multiple spending and lending programs.
As for S&P earnings in 2021, the average Wall Street estimate is $168, ahead of 2019’s $161 and well above this year’s depressed $138. Our experts mostly see earnings topping $170, with stock prices anticipating the gain in a strong first half of the year.
The past year’s—and decade’s—undisputed stock market winners were fast-growing, virus-resistant, software-focused technology concerns (and Tesla ; ticker: TSLA). Companies such as Amazon.com (AMZN), Netflix (NFLX), and Zoom Video Communications (ZM) might as well have been made for the stay-at-home pandemic economy. Their businesses flourished, while near-zero interest rates encouraged investors to bid up their shares. Zoom, for one, which barely ekes out a profit, has seen its stock soar nearly 500% in 2020. Investors’ hunger for growth, or the promise of it, similarly fueled a stampede into DoorDash (DASH), Snowflake (SNOW), and Airbnb (ABNB), among this year’s hottest new issues.
By the back half of 2021, as the pandemic fades and the economy reopens, it should be much easier to find companies with rapidly growing earnings, our forecasters say. Industrial outfits, retailers, banks, and other businesses far beyond tech could benefit from pent-up demand and easy year-over-year comparisons. And their stocks are much cheaper today than those of the market’s tech leaders. Don’t expect buyers to wait until late in the year to scoop up their shares.
Dubravko Lakos-Bujas, J.P. Morgan’s chief U.S. equity strategist, has the highest S&P 500 target among our group. He sees the index hitting 4000 in the first months of 2021, and drifting up to 4400 by the end of the year, for a potential gain of 19% from current levels. “Equities are facing one of the best backdrops in years,” Lakos-Bujas says. “Risks relating to global trade tensions, political uncertainty, and the pandemic, will be going away. At the same time, liquidity conditions remain extremely supportive, and there’s an extremely favorable interest-rate environment. That’s a Goldilocks environment for risky assets.”
He also points to the potential for corporate stock buybacks to pick up in 2021, and for a weaker U.S. dollar to boost the earnings of multinational companies.
If Lakos-Bujas represents the ebullient end of the spectrum, Tobias Levkovich, Citigroup’s chief U.S. equity strategist, and Savita Subramanian, head of U.S. equity and quantitative strategy at BofA Securities, have lower expectations for the S&P 500, albeit for different reasons. Levkovich suggests that any broadening of the rally, if accompanied by a rotation away from megacap techs, could crimp the index’s gains because of its capitalization-weighted construction.
“One visual I like to use is that of a duck or swan placidly moving along the surface of a pond, but underneath the water, its webbed feet are going crazy,” he says. “Another is that it’s easier to pull a dog sled with huskies than with Chihuahuas. The megacap tech companies are the huskies, but that’s not where the real improvement in trend will be. It will be in the smaller, cyclical Chihuahuas. They’ll just have a harder time pulling the S&P 500 dog sled.”
As a result, he sees the index ending the year at 3800, just 2% above recent levels. Like many forecasters, he recommends overweighting financials, industrials, and health-care stocks in 2021, among others.
Subramanian, who also has a year-end target of 3800 for the U.S. benchmark index, thinks that this year’s market rally has borrowed from next year’s gains. “There will again be a disconnect in how the markets and the economy do in 2021,” she says. “Our view is that the economy sees an aggressive recovery and that corporate earnings see an aggressive recovery, but the market returns are less robust, given that a lot of gains from next year have been pulled into this year.”
Lakos-Bujas has the highest earnings forecast of the group: $178. Saira Malik, global head of equities at Nuveen, TIAA’s investment unit, is just below that, at $177. “This bull market isn’t some well-kept secret,” says Malik. “[Stock] valuations are quite high, and investors are optimistic, so we will need to have that handoff from valuations to earnings growth. But there is upside to the consensus earnings estimate.”
Even if valuations come in a bit, faster earnings growth could mean that the S&P 500 still has room to rise. The index currently goes for a rich 22 times 2021 expected earnings, supported by the low-rate environment. “On absolute metrics like price/earnings...the market is very expensive relative to its history, in the 90th percentile or greater,” says David Kostin, chief U.S. equity strategist at Goldman Sachs. “But relative to interest rates, the stock market is somewhat attractively valued. Those are two different stories—absolute valuation versus relative valuation.”
A flight to safety and the Fed’s massive monetary-policy intervention sent bond prices higher and yields lower this year, making stocks a much more attractive alternative to investors. After dipping below 0.5% in March, the yield on the 10-year U.S. Treasury recently stood at 0.94%, down from 1.92% at the start of the year. On average, the panel expects the 10-year note to yield 1.42% at the end of 2021, still unusually low by historical standards.
“Our core message to clients is that the thing you’ve got to get right in 2021 more than equities is fixed income,” says Lori Heinel, State Street Global Advisors’ deputy global chief investment officer, who will become global CIO in March. “Rates are incredibly low, spreads are relatively tight—although we believe they can tighten further—and if you get an equity selloff, you don’t get the ballast from your fixed-income allocation that you would normally have. Rates are already so low that there’s precious little space for bonds to rally.”
Even “high yield” bonds don’t offer the risk-justifying yields of yore. The ICE BofA US High Yield index, which includes below-investment-grade bonds, yields just 4.5% these days.
“With more robust economic growth, we favor more risk-on sectors [in fixed income] than the safer sectors like Treasuries or other developed-market sovereign debt,” says Rob Sharps, head of investments at T. Rowe Price. “Nobody should own the 10-year here outside of hedging. It’s not an attractive investment unless you’re superbearish.”
Strategists have a similar view of gold. It has a role in a portfolio as a diversifier but isn’t likely to have another year of outperformance as investors’ preference shifts to riskier assets. The group’s average forecast is for gold to end 2021 at $1,881 an ounce, about even with its current level.
For those seeking income, Sharps recommends alternatives to bonds, including bank loans, available through the T. Rowe Price Floating Rate fund (PRFRX), with a 3.4% yield. Invesco Senior Loan (BKLN) is the largest exchange-traded fund in the space, and currently yields 2.8%.
See also: Barron’s Top 10 Stocks for the New Year
In U.S. corporate debt, some high-yield bonds deserve a look, Sharps says, including those of companies that until recently were rated investment-grade. The VanEck Vectors Fallen Angel High Yield Bond ETF (ANGL) yields 3.7%, and includes debt issued by companies such as Carnival (CCL), Newell Brands (NWL), and Occidental Petroleum (OXY). With an improving economic backdrop, the downside risks to such companies are smaller than their upside potential, says Sharps.
Heinel and other strategists also like local-currency emerging market sovereign and corporate debt, which sports higher yields than developed-market debt and could offer some currency return. A weaker U.S. dollar in 2021 is another near-consensus forecast.
An improving global economy is also a tailwind for emerging markets, which tend to be more cyclical than developed markets. Emerging market bond ETFs include the VanEck Vectors J.P. Morgan EM Local Currency Bond (EMLC), which yields about 4%, and the SPDR Bloomberg Barclays Emerging Markets Local Bond (EBND), yielding 3.3%.
Perhaps the most pressing question for the latter half of 2021 is the path of inflation—and on that, there’s little consensus. There are good arguments for both a snappy pickup in prices and a continued slow rate of price growth in the U.S. and other developed economies.
“I’m not in the inflation camp, but I’m monitoring it, because that will probably be the make-or-break variable for 2021 and beyond. ”
— Edward Yardeni
On one hand, the money supply has ballooned in 2020, as central banks have embarked on unprecedented easing campaigns, with a nearly 25% increase in the supply of U.S. dollars just in the past nine months. Interest rates remain near zero, and savings-rich consumers’ pent-up demand could outstrip supply in numerous pockets of the newly reopened economy later in 2021. In addition, the mammoth government deficits around the world aren’t going away anytime soon. And, under the Fed’s new policy framework adopted this year, officials won’t be proactive in stopping inflation from running hot in the coming cycle.
“I’m not in the inflation camp, but I’m monitoring it because that will probably be the make-or-break variable for 2021 and beyond,” says Edward Yardeni, president of Yardeni Research. “If inflation makes a significant and sustained comeback, the Fed is going to have to let interest rates go up. The impact on stock valuations, on compounding debt, on these zombie companies that have been able to stay in business only because of record-low interest rates—they’re toast.”
On the other hand, postpandemic spending may prove to be only a temporary inflation shock, and the unemployment rate will remain high, dampening wage pressures, while commercial rents—a contributor to services inflation—aren’t likely to snap back suddenly. And, the same disinflationary forces that have weighed on price growth over the past decade are still in place. Those include an aging population that prioritizes saving over spending, and technological improvements that reduce costs and boost productivity.
Still, the potential implications of a steady rise in prices could be severe, especially if the Fed and other central banks respond with higher benchmark interest rates. Heavily indebted firms and governments would be left with higher costs and have more difficulty refinancing their borrowings. The stock market could tumble, as lofty valuation multiples are challenged by a higher discount rate. Growth and technology stocks, in particular, would be vulnerable to selloffs.
Wall Street is likely to focus more on all of these possibilities in the second half of 2021.
As for Fed policy, all 10 strategists and CIOs with whom Barron’s spoke take officials at their word that the central bank won’t be raising interest rates anytime soon. The panel is unanimous in thinking that the federal-funds rate will remain at a targeted range of 0.00% to 0.25% at the end of 2021. But several see the potential for a reduction in quantitative easing in the second half of the year, from the Fed’s current purchase pace of at least $120 billion of bonds a month.
If the U.S. economic recovery unfolds as anticipated and inflation appears, then a change in tone from Fed officials may be in store—from “not even thinking about thinking about raising rates,” to “thinking about thinking about raising rates,” perhaps as soon as in 2022. Expect stock and bond markets to react to that messaging shift well ahead of any actual changes in target rates.
Banks, and bank stocks, would be the primary beneficiaries of higher long-term interest rates, given the industry’s business model: borrowing at short-term rates and lending at longer-term ones. Malik calls Bank of America (BAC), Goldman Sachs Group (GS), and Morgan Stanley (MS) her favorite picks among the group.
Financials, broadly, have several fans among these forecasters. Cheaper relative valuations, cyclical exposure, and a steepening yield curve are all tailwinds for the sector. The possibility of more stringent bank regulation appears to be off the table, even if Democrats win both Georgia Senate seats next month. Plus, the big banks may have overreserved in 2020 for possible loan losses, giving them additional capital to put to work in 2021.
An improving economic backdrop lessens credit risk and makes it more likely that the Fed will greenlight larger capital-return programs for the banking industry—a big contributor to financials’ performance in recent years.
Michael Fredericks, head of income investing for BlackRock’s Multi-Asset Strategies team, emphasizes companies with the ability to increase their dividends in 2021—including financials. He sees a broader base of investors in fixed income shifting some of their allocation to dividend growers, noting that many companies in the S&P 500 have a higher dividend yield on their equity than on their debt.
“Relative to where bond yields are now, dividend yields continue to be pretty noteworthy,” says Fredericks. “Fixed income says it right on the label, that income is fixed. Being able to find companies with an income stream that will grow over time is really valuable. And there’s little to no price-appreciation potential in the [investment-grade or high-yield] bond markets, unlike these dividend-growing stocks.”
Fredericks also sees dividend-growth potential in health care, another popular overweight. Election-related risk seems diminished here, too, and the sector is a cheaper way to get some growth exposure than technology. Vaccine champion Pfizer (PFE), for example, yields 4.1%, having increased its first-quarter dividend payment this month. Insurer UnitedHealth Group (UNH) is expected to grow earnings at about 12% annually in coming years, and its stock yields 1.5%.
Bond-proxy sectors, including utilities, real estate, and, to some extent, consumer staples are near-consensus underweights among this group. Those areas of the market do well when investors get defensive and interest rates fall. Strategists expect 2021 to favor the opposite on both counts.
Much will depend in the year ahead on a smooth rollout of vaccines to protect against Covid-19, the disease caused by the coronavirus. Any mutations in the virus that could extend the pandemic would cause Wall Street to rethink its bullish stance.
Humanity is due for some good news and good cheer, however, so let’s hope for the best in the medical sphere—and that the postpandemic world brings even more opportunities for investors.